Analysis of current economic conditions and policy

Thinking about the Double Dip Recession in the UK

The news is well-known now: There the UK is in the first double dip recession since 1975 thanks to among other things the government’s contractionary fiscal policies. This recovery is in fact worse than that of the Great Depression [Macroscope] Here are three other observations that might not be so obvious: (1) Growth has been lackluster ever since the election of the coalition government in May 2010; (2) growth under the program of austerity has compared poorly against the (admittedly insufficiently stimulative) fiscal policy framework in the US, and; (3) UK GDP growth has been lackluster even with the depreciated pound, which is interesting given that exchange rates can act as a shock absorber.

UK growth has been lackluster since 2010Q2

I found it notable that UK growth has been so weak ever since the implementation of the austerity program. In some ways, it’s “textbook”. Figure 1 shows growth in log differences since 2009.

I was slightly surprised that the UK growth had lagged so much against US growth, given that obstructionism in the US political system had prevented implementation of additional pro-growth policies. But the current policy framework in the UK seems even more anti-growth than that in the US. Of course, (unlike Professor Ed Lazear), I recognize the fact that growth in the wake of financial crises is on average slower than those not accompanied by such crises. With a larger proportion of UK GDP involved in financial activities, one might expect extra headwinds.

Nonetheless, it’s clear the contractionary fiscal policy has not attained the objectives sought. According the IMF’s Article IV report from 2011, FY2009/10 structural budget balance, was -5.3%. The FY10/11 budget balance, under the new government, was -4.5%. The programmed (cyclically adjusted) balances in FY11/12, FY12/13, FY13/14 were -3.2%, -2.0%, and -0.6%, respectively (and into surplus in subsequent years!) according to the March 2011 budget. Most reasonable models would predict contraction and that’s what we get.

Austerity in a (relatively) small, open economy is still not expansionary

The UK economy is about one sixth the size of the US evaluated at current exchange rates. If there was a country where the expansionary fiscal contraction scenario could play out, it would be there.

And yet, with a pound some 20% depreciated (log terms) below levels at the beginning of 2007, the UK economy has struggled to exceed zero growth. I predicted back in November the UK would go into official recession, and here we are. It is no wonder that the troubled economies of the euro zone, lacking the exchange rate shock absorber, and operating at the zero interest rate bound, should be slipping deeper into recession. In other words, expansionary fiscal contractions might be little more than a curiousum, much more a fevered fantasy of the Republican members of the Joint Economic Committee and Paul Ryan than anything else. (See also Simon Wren-Lewis on why expansionary fiscal contraction is unlikely to work in the UK context.)

The implications for the US

Now let’s consider a fiscal framework that entails spending reductions relative to baseline, at close to the zero interest bound, and without much room for dollar depreciation. That scenario would be closely mimicked by programs such as the Ryan budget plan (unless one believed in some implausibly high elasticities as in the Heritage Foundation’s “analysis” of last year’s incarnation [1][2][3]).

I think the fact that fiscal drag is greater now is not surprising given that the share of fiscal consolidation coming from spending cuts is rising. This is shown in Figure 4, from the IMF’s Article IV report (p. 35).

So, we too can make the current US recovery worse than that of the Great Depression; just implement a front loaded fiscal contraction, heavy on spending cuts. Furthermore, in order to maximize the contractionary impact, harass the monetary authorities to tighten policy by inciting fears of high inflation (à la Rep. Paul Ryan), when year-on-year inflation as measured by the personal consumption expenditure deflator is 2.1%.

(More on the UK, from Interfluidity, which stresses the Neoclassical synthesis vs. New Keynesian vs. Post-Keynesian interpretations. I believe the data are not puzzling from an open economy perspective but that might reflect my training; deficient aggregate demand and relatively high inflation can occur when there is a large imported share in GDP.)

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26 thoughts on “Thinking about the Double Dip Recession in the UK”

The Oxford Group, at the behest of Fitch, has estimated the impact of fiscal policy on US output in 2010 and 2011. Oxford says 4% of GDP. GDP grew by something like 4.8% in that period, so stimulus efforts account for a little over 80% of growth in the past couple of years. Well, that helps make sense of estimates that the “fiscal cliff” in Q1 of next year amounts to about 4%-5% of GDP. Happy sledding.

I’ve been thinking about the mechanism implied in the concept of austerity. We take for granted that people act in their own best interests. We can quibble about whether we act rationally or not and how individual behavior aggregates into collective measures.
The idea behind austerity is that it inspires confidence by showing the state – at x or y level – is more solvent going further into the future. We can argue about the definitions of solvency – as in, deferred infrastructure maintenance and construction can be treated as a future debt – but that seems to be the general idea.
Austerity is a present cost. This, I think, is where the argument for austerity tends to be misunderstood. If you in your personal budget, reduce spending, you see that as reducing your costs. You are reducing the amount you spend on goods and services from others and that is a cost to them because it reduces their revenue. As I see it, people confuse their personal situation with the mandatory effect: your saving is a cost to others.
One oddity in that misunderstanding is the proponents of austerity also tend to claim that government spending displaces private investment. That means they claim offsetting reactions in one case and then deny offsetting reactions in another. If you cut government spending, you save money and cost others money.
So how would austerity work? Put aside notions that say pain is necessary, that you need to prune the garden by hurting people and being cruel. Those are about long term solvency and the long term effects of rational fiscal policy. The point of austerity, as often claimed, is that it is a better short term policy. The only rationale I can identify that fits is that austerity would somehow appeal to “animal spirits”, meaning belief, meaning the actual claim for short term benefits from austerity is that people will somehow decide that this is good for them. That runs counter to pretty much all economic theory in which people act for their own benefit. It reeks to me of communism: believe in the greater good instead of the individual and sublimate your interests to those of the greater good. If we are indeed based on pursuit of self-interest, that is a triumph of belief over logic.
A nation isn’t a family. A state isn’t a family. We don’t share genes. We are adults, not children in the care of parents. No one outside your actual family cares whether you succeed or not.

I have never understood the expansionary fiscal contraction arguement, at least as short run stimulative policy. Ignoring multipliers, for every dollar cut from government spending, the the rest of the economy needs to somehow make up for that lost dollar, and then some, if the effect is to be stimulative over a year or 2. Any cuts in the level of government spending should be made when the economy is rapidly expanding.
One thing I like about the Ryan plan is that it promotes cuts to the growth rate in spending, not the level of spending. In Obama-Speak, it bends the cost curve.
Unfortunately, many people have succumbed to the absurd notion that a cut in the growth rate of spending is the same as a cut in the level of spending. The term “Draconian” comes to mind and is often used by leftists to describe proposed reductions in the growth rate of government spending.

So what’s going on here? Krugman wants to end this depression now; Jim’s talking about the limits of the Fed’s capabilities.
You would think that we were in a recession, not nearly three years into the recovery. Are we in a recession? Taking a breather during a depression? Where are we, exactly?

A bit of a side question, but: I keep hearing that recovery from a financial crisis is slow. And I understand that there’s a correlation in the historical data. But I’ve never understood the mechanism. Why should a banking crisis in 2008 be affecting aggregate demand in 2012?
Or is it not causative, just a correlation? Banking crises happen when banks realize that assets they hold are not worth what everyone had previously thought they were worth; and when that happens, other people (households) are reaching the same conclusion about the assets they hold, and trying to reduce spending to repair balance sheets. It’s really the negative wealth shock in the household sector that leads to the slow recovery.
And if that’s the case, then it doesn’t follow that UK’s recovery should be especially impaired due to their outsized banking sector. Their banking sector is outsized because they do a lot of international banking for Europe and Asia; their recession/recovery would depend only on wealth losses and reduced demand by British households.

Menzie,
It’s by no means obvious that Lazear should have conditioned on a financial crisis. See http://media.hoover.org/sites/default/files/documents/Bordo-Haubrich-Steep-Paper-SNB%209_7.pdf for example. But whatever you believe about that, Lazear was conditioning on policy. He was saying that the current US recovery need not have been so poor if we had had more effective policies over the last few years. The UK responded to the recession by raising capital gains tax rates, by raising the VAT, and by imposing higher marginal income tax rates, exactly the opposite to the policies that Lazear would have recommended.

Rick Stryker: I agree that Professor Ed “We are not in a recession” Lazear was conditioning on policy. That is not in dispute. What I highlighted was that he mentioned R&R’s work, then dismissed it, to then condition on depth of recession, ignoring work that he surely must have been aware of.

Regarding the Bordo-Haubrich paper, let me observe that when the sample is relatively small, I tend to go for bigger samples, and in particular, cross-country historical samples where I have a better feeling for the data (i.e., do I know GDP is really GDP?). Hence, why in my original post, I cited the IMF’s work.

Aaron –
The tsunami affected Japan, which explains much of recent Japanese economic performance.
There was no tsunami in the Netherlands. Why is the Netherlands teetering into recession now? Why did Euro unemployment begin to esacate last spring, with no peak in sight yet?
I am under the impression that economists are scratching their heads right now, wondering why economic growth is so weak. The vocabulary we see–from Jim or Krugman, for example–is more reflective of a period of recession than of recovery.
I think–but do not know–that oil is the primary reason. (Just how bad is the fuel supply situation when an airline thinks it’s a good idea to buy a refinery?) There is very little serious research into the matter (we are trying to organize a project with a sponsor now).
Moreover, there is good reason to believe oil price pressures–and declining OECD consumption–are not going away. That much is reasonably clear. So OECD oil consumption is going to decline, and right now, it looks like it’s going to decline at a good pace. What will be the effect on the OECD economies? Sluggish growth? That seems reasonable. But is it true?

First, I don’t know if Menzie realizes it or not but the UK does not use the euro.
Second, when all you have is a hammer everything looks like a nail. In the Keynesian demand theory world every thing is predicated on increasing demand whether there is supply or not. “Don’t worry,” says the Keynesian, “the supply will magically appear when increased demand clears the shelves.” Of course they have quickly forgotten the Soviet Union. Clean shelves to not mean supply will be stimulated.
Third, Sweden appears to be doing it right. Since the 1990s they have been in the process of a slow reversal of their government programs. Prime Minister Fredrik Reinfeldt has always promoted moderate reform in Sweden. He was elected to the position in 2006 and guided Sweden through the turbulent times of the Great Recession and now Sweden has one of the most successful economies in Europe. Reinfeldt has slowly turned social programs over to the private sector and has also slowly reduced taxes. While socialists point to Sweden’s still high tax structure it is the trend not the absolute rate that is allowing Sweden’s economy to remain strong.
So neither Keynesian massive government spending nor government austerity has proven itself. What has proven itself time and again is a moderate shift from central planning to free markets and allowing producers to produce.

lilnev,
I don’t know if I’d say demand is down because of the crisis or that the crisis happened because demand went down. It’s definitely both, but I think more that the demand fall triggered the crisis. It mostly happened because of a sudden dramatic tightening of lending standards.
The main reason demand remains so low is that mitigating the impact of bubble debt has been ridiculously inadequate. I think this post describes our situation nicely: http://www.interfluidity.com/v2/3310.html. If instead of stimulus the government had directed money refinancing or writing down healthy but underwater mortgages, we’d be in a full-on recovery.
Obama’s refi-programs will help quite a bit, but it is too little too late.
And now I don’t think it is politically feasible to borrow the money needed to lend to enough bubble mortgage borrowers.

I don’t understand why a country with an 8-10% deficit/GDP in 2011- I get this as higher than any country in Europe except Greece, Spain, and Ireland- is being treated as “austerity.” Is it just because the deficit was slightly higher in 2010? And yes the U.S. recovery has been better but why use n=2 when you can include the various Euro countries (such as Germany?), Canada, Australia…

Rick Stryker The UK responded to the recession by raising capital gains tax rates, by raising the VAT, and by imposing higher marginal income tax rates, exactly the opposite to the policies that Lazear would have recommended.
These look very similar to the policies President Obama is promoting. Uncanny.

First, I don’t know if Menzie realizes it or not but the UK does not use the euro.

You might have gotten some inkling that I realize this given that Figure 3 and succeeding paragraph refers to the UK effective exchange rate. This suggests to me you don’t actually read the posts before going into automatic pilot anti-model mode.

Menzie,
You wrote:It is no wonder that the troubled economies of the euro zone, lacking the exchange rate shock absorber, and operating at the zero interest rate bound, should be slipping deeper into recession.
I can see that perhaps you did not mean to confuse this with the pound as I originally read it. I am sorry for the error on my part if that was the case.

The Japanese quake and tsunami occured on March 11, 2011. That day Brent was at $114.
Brent peaked at $127 on April 27.
Brent was at $119 as late as this past Monday. It’s at $114 today.
Now, if the tsunami caused the recession, then we would expect oil prices to have fallen. In fact, they rose, and even a year later, are at the same level as the day of the quake. Europe, of course, is not at the same level as a year ago.
Therefore, the thesis that the quake caused the current recession there is not consistent with the path of oil prices subsequently.

Steven Kopits I think there’s an inherent tension in your arguments. Perhaps I’m misunderstanding the theme of your posts, but on the one hand you seem to support policies that would help make oil cheaper. On the other hand you seem quite devoted to the theory that oil shocks (and apparently only oil shocks) are responsible for recessions. Now I don’t think anyone would deny that some oil shocks were responsible for some of our recessions. And I don’t think anyone would deny that oil shocks can contribute to a recession even if they aren’t the primary cause. But if you believe that volatile oil prices and oil supply instability are such a grave and continuing threat to macroeconomic stability, then isn’t that an argument for wanting permanently higher oil prices? More specifically, isn’t that an argument for wanting a very steep gas tax that could be adjusted downward to absorb sudden price hikes and adjusted upward to dampen demand if there are temporary oil gluts? If you believe that oil prices are critical to macroeconomic stability, and I take it that you do, then you have to make a choice between macroeconomic stability and volatile oil prices. You really can’t have both given your view of how oil prices affect the macroeconomy.

Ricardo: The operative part of the phrase you quote is ‘lacking the exchange rate shock absorber.’. The clear implication is: Britain is having a double-dip, even WITH a 20% pound devaluation exchange rate tailwind, no wonder other economies, lacking that tailwind due to the euro standard, are struggling.
Here’s hoping that the rest of the eurozone climbs down off the German cross after the French election. Here’s hoping the Lib Dems revolt from their unnatural misalliance with the Tories and that Labor takes a parliamentary majority and relegates the Tories to minority status for a generation.

Avoiding a Lehman 2 and a Second Great Depression.
I’m afraid a second Great Depression is a possibility.
The only doctor that can cure the problem is the G20.
The debt situation is far bigger than 1929 when many US citizens jumped on the stock bubble with credit. But many would be less than 10% unlike the many that jumped on the worldwide property bubble.
We cannot unilaterally change our interest rate without consequences affecting FOREX, capital movements and balance of trade. The US can.
The US is like the sun and the rest of us are like planets. If the US gets hot or cold the rest of us get hot or cold.
We have just witnessed a bubble busting, the tech bubble of 2001. We couldn’t possible walk right into another but we did.
The tech bubble burst thanks to tiny calculations showing that the emperor had no clothes and 90% of the new Internet companies disappeared overnight. It cost the US 2m jobs and Alan Greenspan took advantage of the US’s reserve currency status to reduce interest rates every 6 weeks 11 times in a row.
I’m not looking at any references. This is all from memory. I follow these things like a hawk.
Easy money put on 7m new US jobs
When the US reduces interest rates we, and others, can follow and we did. We went down to 3.5% and it occurred to me that that was ¼ of the base rate when I bought here. Therefore another could get 4 times his mortgage for the same cost as his 1991 mortgage and that is what happened here and across the world.
The UK house price rose to 9.3 times average income when the norm is 3. US house prices went to 6.
We first heard the term sub-prime mortgagee in 2007. But the fact is that since Carter the NINJAs basically had to be given a mortgage and if he didn’t get one he could get legal assistance from Barac Obama, the solicitor, to get his right to a mortgage. The banks found a way of selling on sub-prime mortgages as securitized bonds (mortgages are securitized loans as the lender has his name on the title and can reposes the asset and sell it if the mortgagee fails to pay). The rip roaring Northern Rock was giving 125% loans but it was selling them on and was outstanding in the building society market with a great business model for many years.
Securitized bonds paid as much as 18% and there was massive appetite for them. The more sub-prime the better the bond paid and house prices just went up and up and up (as bubbles do). US banks were actively seeking NINJAs and Northern Rock was reaping them in with its 125% deals. In the US you got a three-year easy start to draw you in. These bonds were triple A and when you think that interest rates in Japan were 0% for seven years you can see where the appetite came from. Foreigners held 80% of US treasuries. They were AAA and paid 4% when your bank paid 0%. Buyers of MSB looked no further than the 18% and the word “securitized”.
So my point is that the US, with its reserve currency status, had a licence to reduce interest rates and it paid them well, putting on 7m extra jobs and expanding GDP. The cost of Medicare and Medicaid increased 10 fold in twenty years and Bush signed the cheques. The cost of Iraq was small fry by comparison. The US debt ceiling was increased with a nod some twenty times and no one was bothered.
That is what was happening to the world economy. The sun was getting hot and we all benefited from the low interest rates.
But back home we were wanting in parliamentary debate and scrutiny. This is what parliament does. The massive Labour majority of 1997 led to a situation where it was not necessary for Labour MPs to attend debate but only to attend for the vote. Typically few or no Labour backbenchers attended a Finance Bill debate. Try keeping Ken Clarke, John Redwood or Peter Lilley away when money was on the table. But Labour MPs, who actually thought that GB was a super economist (when he only studied modern history), never received or contributed to debate and scrutiny.
Labour (when we talk about labour we are only talking about the handful of middle class privately educated politics, philosophy and economics graduates, PPEs, who traditionally take all the top jobs) (prior to 1965 every member of a conservative cabinet had a PPE from Oxford, you need a PPE to govern) jumped on the easy money decade. They borrowed £30-£40b every year since 2003, grabbed £15b pa from pension funds (forcing employers to scrap their defined benefit schemes or fund the missing £15b from profits which in turn takes £15b from investment in UK wealth creation), drove people into property as the FTSE suffered the loss of £15b pa, ran up an off-balance sheet debt of £300b in PFI, allowed mortgage debt to sky-rocket to £1.2t, allowed £400b of home equity release and allowed banks to multiply their lending reserve by as much as 30 times deposits.
The result is that today we have personal debt of 1.06 x GDP, corporate debt of 1.26 x GDP and sovereign debt of 89% of GDP. All affordable when interest rates are low but all having to be paid back.
Debt is where you go when you cannot make ends meet. It is bringing forward future earnings. It is like earning £100 per week and taking a one-week sub and telling everyone you are on £200 per week.
GDP is measured in three ways that all give the same answer. It is basically the summation of all transactions. It peaked at £1.5t in 2007, as did personal debt (£1.2t of which was mortgages).
Nevermind GB’s claim of 53 quarters of growth and the best chancellor ever. Just looking at a simple model; personal debt rising from 0 to equal to GDP between 1997 and 2007, and assuming it is linear, it takes real GDP from +3% to –7%. We were spending money and providing jobs that derived from home equity release, PFI, mortgages and personal, corporate and sovereign loans.
30,000 extra doctors, 90,000 extra nurses, 80,000 teaching assistants and 118 brand new schools in 2007. It all sounded great. A doubling in the spend on pupils pa and a tripling of NHS spend but all based on borrowing and not what we can afford but passed off as the latter.
The illusion was first broken when the Daily Mail ran the story that 90% of all the new jobs that Labour boasted about went to migrants who came here from 2004 onwards to get paid 6 times what they could get back home for the same work. The £ fell and the Ztolti rose and many went home but we still have 1.35m doing work that Brits will not do because they are much better off on benefits. Then it transpires that many of the 5.2m Brits on benefits are basically unemployable and industry will always choose a migrant over a Brit because the Brit is less educated, less presentable and has a lower work ethic.
I broke the story that to halve the deficit in four years also meant to increase the national debt in five years. I put it on lots of financial sites prior to the election. Obama first used the phrase and I thought it was good news until I realised that he would be halving the deficit and not the debt. Labour picked up on it and even made it law and I knew it was a persuasive mantra.
You only had to add a few numbers together to understand that halving the deficit in four years meant doubling the debt in five. Debt was £650b. Add £178b, £130b, £110b, £89b and a further year and you doubled the debt. I posted it on Jeff Randall’s Telegraph column and the following day was budget day. He never mentioned the budget on his Sky news show when every other channel was budget, budget, and budget. He just repeated that debt was different to deficit and the debt would double in five years. The Treasury Secretary, Steven Timms, was a guest and Jeff asked him what would happen to debt and Steve didn’t know. Jeff pointed out that it would double and that it was in the budget document that Steven had just written.
We are paying £43b pa in debt service charges and this will grow to £63b at the end of the coalition term. But we will miss this target, as it is so difficult to get the structural deficit down to 0 in a five-year term.
Please ask yourself what you think about halving the deficit in four years? It does mean paying £120b pa in debt servicing in four years time, equal to the cost of the NHS.
The NHS costs £120b pa, out of a total government spend of £700b pa, of which £200b goes on benefits and pensions. Does any one really think that paying the cost of the NHS in debt service charges is a good idea?
The numbers are the key to understanding the problem and understanding a problem is the key to solving it.
Management is what we need.
Spending money on the most vulnerable in society was hard to control and ended up multiplying the poor are diverting money from the most vulnerable in society.
We introduced IB (incapacity benefit) for a target audience of 175,000 but soon there were 20 times that number claiming that they couldn’t work a day in their lives due to incapacity. Including 200,000 teenagers.
We went easy on single mums and their numbers grew by three fold in the last twenty years. Often due to LAT’s (live apparts). Those who choose to recover the lost income of the female when a child occurs by claiming to live apart and get everything funded by the state (or as I put it, by their neighbour).
We have to swallow some facts about Labour’s Britain that are not well aired by the media.
-The BBC delighted in telling us that the kids would go back to 118 brand new schools in September 2007 but omitted to tell us that even the primary school children would have to pay the PFI (generally 17% pa over 20 years) as it would load their council tax in years to come.
-600,000 LAT’s all getting all their home bills paid by the taxpayer.
-a career choice for 3.5m, less 175,000, was to graduate from JSA (job seeker’s allowance) to IB for the extra money and to save Labour the embarrassment of high unemployment figures. The most common illness being depression.
-1.35m quest workers doing the work we refuse to do.
-14,000 children excluded from school who will never learn to read and write.
-the average cost of a truant was £2m some 15 years ago. Yet we have more truancy today than ever.
-15% leave school with no qualifications despite a doubling of the spend on schooling.
-public sector workers get 43% greater remuneration than private sector workers doing the same work when their 7% extra wages, lower hours, longer holidays, earlier retirement and better pensions are accounted for. The reason being that for 13 years the union (Labour) has sat in the employer’s chair.
-only 64% of working age men work, one in four children live in a home without a father (2m children), 5.2 m of working age do not work, one in four households of working age has no worker.
This list is endless.
I have not mentioned all the assaults on employers. We are beginning to realise that we quite like employers as they provide employment. That is what it says on the can. If you kill an employer you loose the tax they provide and the rest of us have to pick up the tab for benefits necessary to fund the workers that he funded before you hit him with CGL (climate change levy), NMW (national minimum wage) and increased employer NI and UBR (uniform business rates).
None of the Labour stimulus went to employers.
Going forward.
Before going forward let us please get the problem properly identified. There is no point in trying to solve the wrong problem.
Do we all agree that the above is the correct characterisation of the problem?
David Lilley
3rd September 2011.
We are of course struggling with deleveraging at the moment.

Thank you for accepting my first and only blog. It may be of little interest to you because it is UK centric but there are two hooks as big as that of Abraham’s.
1. I have tempted you with the offer of a solution to the “Debt Crisis”. I posted this over three years ago and I am still generally happy that it is the solution and we have generally been working this path.
2.I am not in the blame business when there are so many problems to solve. But I have generally identified the origin of the debt crisis on your soil.
Two big hooks. Any takers.
But remember your Popper. Its not economics or just one discipline. There is only one game in town “problem solving”. 63% of your working age population don’t work and your servants, doing your bidding, have run up a national debt of $70,000 per working person and it is still growing.